AP Macro Lecture Guide from the Federal Reserve
- 1. 1 AP Macro Lecture Guide: How the Federal Reserve Implements Monetary Policy How does a central bank conduct monetary policy to achieve price stability and full employment? The Fed’s Toolbox
- 2. 2 Dual mandate – The Federal Reserve’s responsibility to use monetary policy to promote maximum employment and price stability. • Maximum employment – The highest level of employment that an economy can sustain while maintaining low and stable inflation. The Fed’s policy decision is informed by its assessments of the shortfalls of employment from its maximum level. • Price stability – A low and stable rate of inflation maintained over an extended period of time. The Fed seeks to achieve an inflation rate that averages 2 percent over time. The Fed’s Toolbox
- 3. 3 Federal Open Market Committee (FOMC) Committee = 12 Reserve Bank Presidents + 7 Governors = 19 Voting = 5 Reserve Bank Presidents + 7 Governors = 12 The Fed’s Toolbox
- 4. 4 FOMC meeting at the Federal Reserve Board of Governors in Washington, D.C. The Fed’s Toolbox
- 5. Summary of path from the FOMC policy rate target to the Fed’s dual mandate: • The FOMC sets the target range for the federal funds rate. • This affects market interest rates and overall financial conditions. • This also influences the decisions of households and businesses. • It ultimately affects employment and inflation. The Fed’s Toolbox
- 6. The Fed’s Toolbox The Federal Funds Rate is the Fed’s Policy Rate • Banks hold cash in their “checking accounts” at the Fed, called reserve balance accounts. • Banks that need funds can borrow from banks that have excess funds. • The transfer of funds from one bank’s reserve account to another bank’s reserve account is termed a federal funds transaction, and the agreed interest rate in this transaction is the federal funds rate (FFR). • The FOMC sets a target range for the FFR, which is the Fed’s policy rate.
- 7. The federal funds market is where banks that need reserves go to borrow cash from banks that have excess reserves. For each transaction, reserves are transferred from the lender’s reserve account at the Fed to the borrower’s reserve account. The federal funds rate is market-determined by the borrowers and lenders. The Fed does not set the federal funds rate. The Fed’s Toolbox The Federal Funds Rate is the Fed’s Policy Rate
- 8. The Fed sets a target range for the FFR, which is where it wants federal funds transactions to take place. The FFR influences other interest rates in the economy, as well as the spending and investing decisions made by consumers and producers. The Federal Funds Rate is the Fed’s Policy Rate The Fed’s Toolbox
- 9. 9 The FOMC Target Range, 2015-2023 The Fed’s Toolbox The FOMC sets a target range for the FFR; this range has been 25 basis points (or 0.25%) wide.
- 10. 10 The FFR Is In the FOMC’s Target Range The Fed’s Toolbox The Fed uses its monetary policy implementation tools to ensure that the federal funds rate stays within the target range.
- 11. Question: How does the Fed ensure its target range for the federal funds rate transmits to market interest rates? Answer: The Fed implements the FOMC’s policy decisions using its administered interest rates. The Fed’s Toolbox
- 12. The Fed’s Toolbox Policy Implementation Tools 1. Interest on reserve balances 2. Discount window 3. Open market operations Administered Rates 1. Interest on reserve balances rate 2. Discount rate 12 The Fed’s Toolbox
- 13. 13 Monetary Policy with Ample Reserves The Fed’s Toolbox “Ample reserves” means the supply curve intersects the demand curve where small changes in the supply of reserves will not affect the policy rate; this occurs on the flat part of the demand curve.
- 14. Policy rate: The interest rate that a central bank sets a target for; it is used to communicate its monetary policy stance (or position). The Policy Rate The policy rate is determined by supply and demand
- 15. Supply curve in the ample reserves (horizontal) part of the demand curve The supply curve is vertical because the central bank ultimately determines the supply reserves. The Supply Curve
- 16. Downward sloping demand curve The demand curve slopes down because as the cost of borrowing decreases, banks are willing to borrow more funds to increase their holdings of reserves. The Demand Curve
- 17. Tool #1: Interest on reserves is the primary tool. The interest on reserves rate is the interest rate that banks earn from the central bank on the funds they deposit in their reserve accounts. The interest on reserves rate steers the policy rate into the central bank’s target range. 17 Administered Rate #1 Interest on Reserves (indicated by the dotted line), serves as the “lower bound” (or floor) of the demand curve.
- 18. Interest on reserves relies on two concepts. 1. Reservation rate Reservation rate: The lowest rate that banks are likely willing to accept for lending out their funds. 18
- 19. 19 1. Deposit excess funds at their central bank and earn the interest on reserves rate. 2. Lend the excess funds out in the reserves market and earn the policy rate. 3. Invest the funds in Treasury bills and earn the given Treasury bill rate. Banks seek to earn a return on their money, and they have several options.
- 20. What would a bank do with excess funds if the central bank’s interest on reserves rate is higher than market rates? IOR is a risk-free investment option that is always available to banks.
- 21. 21 What would a bank do with excess funds if the central bank’s interest on reserves rate is higher than market rates? IOR is a risk-free investment option that is always available to banks.
- 22. Interest on reserves relies on two concepts. 2. Arbitrage Arbitrage: The simultaneous purchase and sale of funds (or goods) in order to profit from a difference in price. 22
- 23. 23 Reserves 2.5% Reserves 2.0% The central bank pays interest on reserves (IOR) Bank Market for bank reserves
- 24. 24 Reserves 2.5% Reserves 2.0% Borrow at 2.0% Deposit at 2.5% Profit = 50 basis points Bank The central bank pays interest on reserves (IOR) Market for bank reserves
- 25. 25 Bank Reserves 2.5% Reserves 2.0% Borrow at 2.0% Deposit at 2.5% Reserves 2.5% Increase in demand for borrowing reserves in the reserves market Other banks also see the opportunity to earn profits by borrowing in the reserves market, which drives up the cost of borrowing in the reserves market, and profits go to zero. The central bank pays interest on reserves (IOR) Market for bank reserves
- 26. Reserves 2.5% How will a bank invest its funds with these interest rates? Bank Reserves 3.0% 26 The central bank pays interest on reserves (IOR) Market for bank reserves
- 27. 27 Reserves 2.5% Profit = 50 basis points Bank Reserves 3.0% Lend at 3.0% Withdraw from reserve account The central bank pays interest on reserves (IOR) Market for bank reserves
- 28. 28 Bank Reserves 2.5% Reserves 2.5% Other banks also see the opportunity to lend in the reserves market, which reduces the cost of borrowing in the reserves market, and profits from arbitrage go to zero. Reserves 3.0% Withdraw from reserve account Increase in supply of reserves Lend at 3.0% The central bank pays interest on reserves (IOR) Market for bank reserves
- 29. 29 Administered Rate #2: The Discount Rate The discount rate is an administered rate that is set above the central bank’s target range, with the intention to serve as a ceiling for the PR (FFR). Administered Rate #2 Discount rate • Serves as the “upper bound” (or ceiling) of the demand curve.
- 30. 30 When the central bank sets the target for the policy rate, it also chooses the level for the administered interest rates that will encourage the policy rate to move toward the target. When the central bank raises the target for the policy rate, it also raises the administered interest rates, which moves the policy rate up into the new target range. When the central bank lowers the target for the policy rate, it also lowers the administered interest rates, which moves the policy rate down into the new target range.
- 31. 31 Supporting Tool: Open Market Operations Open market operations are conducted periodically to maintain ample reserves, or to conduct large scale asset purchases (i.e. quantitative easing). To shift the supply curve to the right, the central bank purchases securities and pays for them by adding reserves to the banking system.
- 32. Interest on reserves rate Discount rate Policy rate The central bank uses the administered rates to steer the policy rate
- 33. 33 Problem: In a banking system with ample reserves, and the economy in recession, the central bank wishes to use policy to reduce unemployment. How can the central bank use its monetary policy tools to achieve full employment?
- 34. Decrease in the policy rate Decrease in the administered rates The central bank lowers the administered rates to steer the policy rate lower. Problem: In a banking system with ample reserves, and the economy in recession, the central bank wishes to use policy to reduce unemployment.
- 35. 35 The central bank lowers the policy rate by decreasing its administered rates. The central bank ensures the policy rate moves higher or lower by moving the administered interest rates higher or lower.
- 36. 36
- 37. Problem: In a banking system with ample reserves, and the economy in recession, the central bank wishes to use policy to reduce unemployment. Market interest rates Consumer spending / business investment (interest sensitive consumption) Aggregate demand Real output Price level
- 38. 38 Problem: In a banking system with ample reserves, inflation has exceeded the central bank’s inflation target. How can the central bank use its monetary policy tools to achieve price stability?
- 39. The central bank raises the administered rates to steer the policy rate higher. Increase in the policy rate Increase in the administered rates Problem: In a banking system with ample reserves, inflation has exceeded the central bank’s inflation target.
- 40. 40 The central bank raises the policy rate by increasing its administered rates. The central bank ensures the policy rate moves higher or lower by moving the administered interest rates higher or lower.
- 41. 41 Policymakers set a target for the policy rate
- 42. Problem: In a banking system with ample reserves, inflation has exceeded the central bank’s inflation target. Market interest rates Consumer spending / business investment (interest sensitive consumption) Aggregate demand Real output Price level
- 43. 43 Key Features Description (AP Macro model) In Practice in the U.S. (Federal Reserve) Policy rate The interest rate that is used by a central bank to set and communicate its monetary policy stance (or position). The FOMC sets a target range for the FFR, which is the Fed’s policy rate. Interest on reserves Interest paid on funds that banks hold in their reserve accounts at a central bank. A key administered interest rate. IORB is the Fed’s primary tool for guiding the FFR; it serves as a floor for the policy rate. Discount rate The central bank’s lending to banks (the "discount window") at the discount rate. A key administered interest rate. The discount window helps put a ceiling on the policy rate (FFR). Open market operations The buying and selling of government securities by the central bank Open market operations are an important tool for ensuring that reserves remain ample and for quantitative easing.
- 44. 44 • How does the interest on reserves rate serves as a reservation rate? • How does arbitrage ensure that the policy rate does not fall far below the interest on reserves rate? • What is the discount rate? • How does the discount rate act a ceiling for federal funds rate? • How does a central bank use open market operations in an ample reserves framework? Review Questions The Fed’s Toolbox